Central bank policy involves setting the interest rates that banks are charged to lend and borrow money. The goal of a central bank is to promote growth in the economy and stability in financial markets while maintaining low levels of inflation (see Explainer: Inflation and its Measurement). Central banks also have broad powers to buy and sell government securities, target foreign exchange rates, and revise the amount of cash that banks are required to hold as reserves.
The decision to change interest rates is usually made by the governing board of a central bank, known as a Monetary Policy Committee. Each member gets a vote and the decision is based on the outcome of the votes, with the Governor casting a deciding vote in the event of a tie.
Most central banks aim for a “dual mandate” of stabilizing output and employment, though some, like the ECB, are more focused on inflation. The goal of stabilizing output ensures that consumers and businesses have enough to purchase and consume, while the goal of ensuring low and stable inflation helps preserve the purchasing power of money over time.
Changing interest rates can have a wide variety of effects on economic activity, from directly impacting borrowing and spending to indirectly altering the prices of goods and services. The primary tool of a central bank for managing these changes is the policy rate, which is typically a short-term (often overnight) rate. However, the Bank can also use forward guidance, target yields, set a quantity target for the purchases of government bonds, and provide low cost long term funding to banks through open market operations.